Ethereum’s burn rate has slumped to historic lows this week, calling the prevailing deflationary narrative into question.
Ethereum’s base transaction fees have been destroyed since the EIP-1559 upgrade introduced the burn mechanism to the network last August. The extreme network congestion of late 2021 and early 2022 resulted in the network producing around three weeks of deflationary days between November and February — meaning that more Ether was destroyed than issued as rewards to validators.
With The Merge just around the corner and set to reduce new Ether issuance by almost 88%, many observers predict that Ethereum will become deflationary by default once it has transitioned to proof-of-stake.
But Ethereum’s plummeting on-chain activity since mid-February appears to have invalidated the deflationary hypothesis.
“With ETH gas consistently less than 10 gwei recently — this causes a slight net-inflationary supply for ETH post-merge,” Cam Crossley, an analyst at web3 venture studio NotCentralised, told The Defiant.
Post-Merge ETH Issuance
In a July 21 conference appearance, Vitalik Buterin, Ethereum’s co-founder and chief scientist, said that annual Ether issuance will equal 166 times the square root of the number of staked ETH after the Merge.
This means that new Ether issuance will be upped at a steadily decreasing rate as more stakers join the network. For example, if 1M ETH is staked, 166,000 new Ether will enter into circulation each year, but if 100M ETH is staked, issuance will only increase to 1.66M Ether.
With more than 13.34M Ether already staked in the Beacon Chain, about 1,661 ETH are set to enter supply daily under proof-of-stake consensus. While this equates to a nearly 88% reduction in issuance compared to the current proof-of-work model, it significantly exceeds the 1,069 ETH that was burned daily on average over the past week.
The burn rate hit a historic low on Aug. 21, when just 603.4 ETH of base transaction fees were destroyed. Average transaction fees are just 4 gwei at the time of writing.
Filip Siroky, a research associate at Rockaway Blockchain Fund, told The Defiant that average fees will need to sit within a minimum range of roughly 27 gwei to 45 gwei for Ether to become deflationary.
He notes that fees have averaged at roughly 40 gwei over the past 6 months, asserting that “it is reasonable to assume that post-merge ETH will become at minimum a near-deflationary asset.”
Siroky anticipates that DeFi protocols and NFT projects will see a steady increase in users and activity, which in turn bids up gas prices and increases the burn rate. He also predicts that “most of the high-valued transactions will continue to happen on Ethereum because of [its] security and composability” despite the increasing adoption of its low-cost Layer 2 ecosystem.
“Users are much less sensitive to paying a $10 fee when making a multi-million dollar transaction or smart contract interaction, so there will likely always be demand for Ethereum blockspace even if L2s become >1000x cheaper,” Siroky added.
0xWailord, an analyst at Integral, an Ethereum and Arbitrum-based DEX, also told The Defiant that a growing user base for DeFi and NFTs will likely increase demand for Ethereum’s blockspace and push the burn rate higher.
“I think L2s will also contribute, as they store more data on-chain from larger user volumes,” they said. “A world where there is a ton of transaction volume on L2 means that ETH fees are likely expensive… I expect that as L2s grow the gas fees they ‘take’ from mainnet are ultimately repaid by gas fees from L2s with more users.”
Crossley said he expects that Layer 2 gas usage will increase until Ethereum’s EIP-4844 upgrade — which will significantly reduce the gas consumption of rollups — goes live roughly one year after The Merge.
“Beyond [EIP-4844] it’s anyone’s guess — I’d wager Ethereum Layer 1 retains the majority of high-value DeFi transactions due to higher security & facilitating value transfer between L2s,” he continued. “We should at least have more clarity around recession and inflation trends, and more time generally allows new participants to slowly re-enter the ecosystem.”